Introduction
The development of investments analysis is managed and represented by ratio analysis that projects and business will be having. Identifying with the examples of a manufacturing company, this analysis will be interested in the risk-adjusted return on capital (RAROC). The adjusted risk return on capital is described as the adjustment on the return on capital based on the element of risk that might be eminent with the investments (Klaassen & Van Eeghen, 2014; Investopedia, 2016). Additionally, the adjustments seem to suggest a valid expectation on the return that the company will be expecting on investment.
Risk Management Systems
Risk management and the return on capital cannot be separated; this is according to the suggestions of Christoffersen (2012) on investment management practices. Describing this in a more detailed position, the interest that risk management has, is identified with the prioritization, and the assessment of willing risk exposure to the risk environment. This therefore, indicates that under risk management, there needs to be set objectives that the investment parties will be seeking to identify with. DeAngelo and Stulz (2015) suggest that investment objectives are developed best with the measurement of the uncertainties that the future performance of projects and business will be having. Additionally, the understanding of risk management is developed as a procedure or a series of steps in investment management.
These are the identification of the risk, the analyzing of the risk involved, the evaluation and the ranking of the risks follows. It is here that risk is described as either low, medium or high to influence the operations of the business. Treatment of the risk and the reviewing of the risk management follow last, having been considered by Christoffersen (2012) as the last stages of risk management and risk measurement.
Differences on Risk Management for Financial Institutions and Manufacturing Firms
There are notable differences in the risk management environments. This can be noted to be coming from the position that the company will have. In this case, the interest that a manufacturing company will be having are different from those of the financial institutions. For example, the financial institution is seemingly exposed in a number of risk environment based on their presentations of having more roots in the different sector in the economy. This suggests that risk management by the financial institutions will be of higher notes compared to that of the manufacturing companies. Financial institution faces risk not only from investments, but from credit risk, the same institution suffers from international risk concern such as those of hedging.
Contrasting this to the position that the manufacturing company will be having, the risk involved in this case are limited to the manufacturing process. The manufacturing process risks are however all based on the real value of the prices and interest used on capital financing changing over time. Therefore, ranking the two industries under risk and therefore subsequently on returns, the financial institutions has higher risk; thus, calls for higher risk management.
RAROC of Simpson Manufacturing Company
In developing the RAROC of a company, the interest is on a number of items of the income statement. These are the revenues, the expenses, the expected losses, the income from capital and the capital invested. Reading from the reports that have been provided by the Simpson Manufacturing company, the calculation of the RAROC for Simpson manufacturing company is presented as follows.
RAROC = (revenues – expenses – expected loss+ income from capital)/ capital invested
RAROC = (749,000,000 – 249,000,000 – 389,000 + 109,021,000)/ 494,308,000 (Simpson, 2015)
RAROC = 1.231
This is, therefore, a measure of the capital adequacy that the company has based on the availability of risk capital
Benefits and Challenges of ROROC System
There have been a number of challenges in the established analysis of risk with investment and capital adequacies (Klaassen & Van Eeghen, 2014). Thus, the challenges of using the RAROC risk assessments measure are the evaluation of expected losses. The valuations of expected losses and subsequently the estimation how much the company will be willing to lose, present a challenge in having the estimation be viewed as true and fair reflections.
On the other end, the benefits that are attached to the use of the RAROC risk measure is developed with the realization of expected shocks in investment and returns. Looking at the expected loss valuation, the interest that investor will be having in decision making can be identified earlier enough referring to the outcomes that might be seen with risk management for investment. Similarly, the benefits are seen with the adjustments that the management can make having developed index measure on risks that the business or the project may be facing.
Conclusion
Reading into the issues and the fundamental of risk management, this research paper has supported its argument with the use of literature reference and financial data on the calculations of risk. The research paper has managed to develop an analysis of the risk management systems based on a compared position of the manufacturing and the financial industries. Thus, risk management has been developed better under the valuation of risks as adjusted by the return on capital. Return on capital, therefore, presents more sense when adjusted for risk. This has been supported with the valuations of the benefits that the RAROC has in assessing risk environment within the manufacturing industry as seen with the Simpson Manufacturing company.
References
Investopedia. (2016). Risk-Adjusted Return On Capital (RAROC) Definition | Investopedia. Retrieved from http://www.investopedia.com/terms/r/raroc.asp
Christoffersen, P. F. (2012). Elements of financial risk management. Academic Press. NY: Academic Press.
DeAngelo, H., & Stulz, R. M. (2015). Liquid-claim production, risk management, and bank capital structure: Why high leverage is optimal for banks. Journal of Financial Economics, 116(2), 219-236.
Klaassen, P., & Van Eeghen, I. (2014). Analyzing Bank Performance: Linking ROE, ROA and RAROC. ROA and RAROC. SSRN, 2(3), 12-18.
Simpson. (2015). Annual report. Retrieved 12.5.2016, from http://www.simpsonmfg.com/docs/AnnualReport2015.pdf
